LEANING TOWER OF EURO? The headquarters of the European Central Bank in Frankfurt.
Photo: Reuters
Photo: Reuters
Despite the new rescue deal for Greece agreed by the European authorities at the end of July 2011, and which also extended more favourable terms to Ireland and Portugal, the euro zone is now caught up in a new wave of sovereign debt fears.
With market concerns shifting to Italy and Spain, both of whose economies (and debt levels) are much larger than the combined economies (and debt) of Greece, Ireland and Portugal, the threat from the crisis spreading from the smaller peripheral countries to the larger euro zone economies has risen sharply.
The perceived potential implications of this deepening crisis and sharply slower euro zone GDP growth in Q2, coupled with mounting concern about the US economy and its rating downgrade, have added significantly to financial market volatility, causing stock markets to slide. This, in turn, has compounded concerns about the health of the banks, notwithstanding the apparently favourable results of the EU-wide stress tests announced in July.
The euro zone authorities have been slow in trying to tackle the problems facing Greece, Ireland and Portugal, with lengthy delays in responding to developments adding to market nervousness. But it was hoped that the rescue package for Greece announced on July 21 2011 would bring to an end the long period of indecision and uncertainty.
Importantly, the new deal for Greece – which also offered concessions for Ireland and Portugal – included private sector participation for the first time. But while this deal offered some cash flow relief to all three countries, the measures have been criticised for concentrating too much on liquidity and not enough on solvency.
The Greek debt swap has put the country into selective default but is modest in scale. Moreover, projections for the debt ratio to stabilise at about 155 per cent of GDP, an unsustainably high level unless investor confidence returns, still rely too heavily on optimistic privatisation plans.
In addition, the Greek economy may well prove to be weaker than officially expected, thus undermining tax revenue assumptions.
The Greek Government is also facing strong pressure from public opinion and the trade unions. We can expect the civil unrest to accelerate due to the latest proposals from the Greek government on increased taxes, decreased pensions and salaries. This will increase the political instability and will cause great difficulties for the government to collect taxes and stimulate the economy.
Overall, the July package now seems insufficient to avoid a second, deeper debt swap, probably involving a reduction in the market value of securities of around 50 per cent or more on Greek government debt. The key question is when this default will occur and how it will be managed.
Our baseline forecast assumes that euro zone governments will prepare this default in order to keep it controlled.
High financial stress
Euro zone policy-making remains hesitant and beset by disagreements. The political barriers to introducing jointly and severally guaranteed Eurobonds look formidable, and even a large increase in the size of the European Financial Stability Facility (EFSF) – to give it the firepower to stabilise bond markets in the peripheral countries – has not been agreed.
Some countries appear reluctant to go along with the limited deal agreed in July 2011, let alone with what appears to be an increasingly pressing need for vastly expanded EFSF resources to allay concerns about the problems spreading to Italy and Spain.
The European Central Bank (ECB) has tried to fill the gap created by the failure to increase the size of the EFSF by stepping up its bond purchases. In the week beginning August 12 2011, it bought 22 billion euro of euro zone bonds, compared with a previous maximum weekly amount of 2.7 billion euro since it started this program in May 2010.
In the following two weeks, the ECB bought a further 21 billion euro of euro zone government bonds.
But it is unclear how long this process will continue given questions about the size of the ECB balance sheet, the extent of asset risk being taken and the capacity for and cost of sterilisation (i.e., offsetting these bond purchases by selling other kinds of paper in order not to increase money supply).
The ECB’s move is probably no more than a stopgap measure – Italian and Spanish debt, at about 2.3 trillion euro, is larger than the ECB’s total balance sheet. And in the next five years, the two countries need to refinance around 1.5 trillion euro of that debt, compared with about 400 billion euro for Greece, Portugal and Spain.
Slow reaction
In order to contain the threat of contagion, the resources available to the EFSF should be boosted to cover the financing needs of Spain and Italy – this is likely to require an almost 700 per cent increase on its current 450 billion euro lending capacity. This would offer a chance for the euro zone to muddle through the crisis until a firmer long-term framework for a Eurobond is established. But, given the political resistance to the loss of sovereignty that this would entail, it will not be a speedy process.
In the meantime, financial stress remains acute in the euro zone periphery and serious strains are also visible in Italy and Spain. Funding costs for banks have risen and credit conditions surveys suggest this may be spilling over into a general tightening of credit to business.
Rising interbank and high-yield bond spreads support the idea that the crisis in sovereign bond markets is spreading into other euro zone financial markets. Mid-September 2011, the spread of the three-month Euribor across overnight interest rate swaps had increased to around 60 basis points (bp), compared with 15bp–20bp in the first half of the year. And internal stresses have now been magnified by the global market sell-off and a retreat from risky assets.
If Spain or Italy were to start to go down the same route as the smaller peripheral countries, even the core countries could no longer be considered immune. Banking and financial sector linkages would inevitably affect all member countries, even the powerful Germany.
At this stage, however, the underlying fiscal position in Italy and Spain is very different to the other peripheral countries; the problem is one of liquidity rather than solvency. But if financing costs for these two countries continue to rise as investor caution persists, this soon might be no longer the case and the threat of rapid and widespread contagion that could engulf the entire euro zone.
More reforms… and closer fiscal union?
The deep and protracted problems facing the euro zone, coupled with the prospect of several years of divergent growth prospects for member states, underline the need for faster reforms in many euro zone countries if monetary union is to survive in its current form.
The key problem facing most peripheral countries, Greece in particular, has been the loss of competitiveness over the years since adopting the single currency. With their narrow industrial bases and labour costs relatively high compared with non-EU countries, the periphery has seen its share of world trade falling steadily, in turn increasing its reliance upon financial market inflows.
As the latter have dried up in the last two years, so the underlying weakness of these economies has become increasingly exposed. A key reform for these countries is greater labour market flexibility and changes to restrictive working practices, which would encourage greater industrial diversification.
Reform of public finances is another key area, and one that has long been neglected in some of the peripherals. Elimination of excessive bureaucracy and waste, and changes to retirement ages and pension entitlements, are all areas that will need to be addressed to help bring down fiscal deficits and put public finances on a sustainable long-term footing.
With market concerns shifting to Italy and Spain, both of whose economies (and debt levels) are much larger than the combined economies (and debt) of Greece, Ireland and Portugal, the threat from the crisis spreading from the smaller peripheral countries to the larger euro zone economies has risen sharply.
The perceived potential implications of this deepening crisis and sharply slower euro zone GDP growth in Q2, coupled with mounting concern about the US economy and its rating downgrade, have added significantly to financial market volatility, causing stock markets to slide. This, in turn, has compounded concerns about the health of the banks, notwithstanding the apparently favourable results of the EU-wide stress tests announced in July.
The euro zone authorities have been slow in trying to tackle the problems facing Greece, Ireland and Portugal, with lengthy delays in responding to developments adding to market nervousness. But it was hoped that the rescue package for Greece announced on July 21 2011 would bring to an end the long period of indecision and uncertainty.
Importantly, the new deal for Greece – which also offered concessions for Ireland and Portugal – included private sector participation for the first time. But while this deal offered some cash flow relief to all three countries, the measures have been criticised for concentrating too much on liquidity and not enough on solvency.
The Greek debt swap has put the country into selective default but is modest in scale. Moreover, projections for the debt ratio to stabilise at about 155 per cent of GDP, an unsustainably high level unless investor confidence returns, still rely too heavily on optimistic privatisation plans.
In addition, the Greek economy may well prove to be weaker than officially expected, thus undermining tax revenue assumptions.
The Greek Government is also facing strong pressure from public opinion and the trade unions. We can expect the civil unrest to accelerate due to the latest proposals from the Greek government on increased taxes, decreased pensions and salaries. This will increase the political instability and will cause great difficulties for the government to collect taxes and stimulate the economy.
Overall, the July package now seems insufficient to avoid a second, deeper debt swap, probably involving a reduction in the market value of securities of around 50 per cent or more on Greek government debt. The key question is when this default will occur and how it will be managed.
Our baseline forecast assumes that euro zone governments will prepare this default in order to keep it controlled.
High financial stress
Euro zone policy-making remains hesitant and beset by disagreements. The political barriers to introducing jointly and severally guaranteed Eurobonds look formidable, and even a large increase in the size of the European Financial Stability Facility (EFSF) – to give it the firepower to stabilise bond markets in the peripheral countries – has not been agreed.
Some countries appear reluctant to go along with the limited deal agreed in July 2011, let alone with what appears to be an increasingly pressing need for vastly expanded EFSF resources to allay concerns about the problems spreading to Italy and Spain.
The European Central Bank (ECB) has tried to fill the gap created by the failure to increase the size of the EFSF by stepping up its bond purchases. In the week beginning August 12 2011, it bought 22 billion euro of euro zone bonds, compared with a previous maximum weekly amount of 2.7 billion euro since it started this program in May 2010.
In the following two weeks, the ECB bought a further 21 billion euro of euro zone government bonds.
But it is unclear how long this process will continue given questions about the size of the ECB balance sheet, the extent of asset risk being taken and the capacity for and cost of sterilisation (i.e., offsetting these bond purchases by selling other kinds of paper in order not to increase money supply).
The ECB’s move is probably no more than a stopgap measure – Italian and Spanish debt, at about 2.3 trillion euro, is larger than the ECB’s total balance sheet. And in the next five years, the two countries need to refinance around 1.5 trillion euro of that debt, compared with about 400 billion euro for Greece, Portugal and Spain.
Slow reaction
In order to contain the threat of contagion, the resources available to the EFSF should be boosted to cover the financing needs of Spain and Italy – this is likely to require an almost 700 per cent increase on its current 450 billion euro lending capacity. This would offer a chance for the euro zone to muddle through the crisis until a firmer long-term framework for a Eurobond is established. But, given the political resistance to the loss of sovereignty that this would entail, it will not be a speedy process.
In the meantime, financial stress remains acute in the euro zone periphery and serious strains are also visible in Italy and Spain. Funding costs for banks have risen and credit conditions surveys suggest this may be spilling over into a general tightening of credit to business.
Rising interbank and high-yield bond spreads support the idea that the crisis in sovereign bond markets is spreading into other euro zone financial markets. Mid-September 2011, the spread of the three-month Euribor across overnight interest rate swaps had increased to around 60 basis points (bp), compared with 15bp–20bp in the first half of the year. And internal stresses have now been magnified by the global market sell-off and a retreat from risky assets.
If Spain or Italy were to start to go down the same route as the smaller peripheral countries, even the core countries could no longer be considered immune. Banking and financial sector linkages would inevitably affect all member countries, even the powerful Germany.
At this stage, however, the underlying fiscal position in Italy and Spain is very different to the other peripheral countries; the problem is one of liquidity rather than solvency. But if financing costs for these two countries continue to rise as investor caution persists, this soon might be no longer the case and the threat of rapid and widespread contagion that could engulf the entire euro zone.
More reforms… and closer fiscal union?
The deep and protracted problems facing the euro zone, coupled with the prospect of several years of divergent growth prospects for member states, underline the need for faster reforms in many euro zone countries if monetary union is to survive in its current form.
The key problem facing most peripheral countries, Greece in particular, has been the loss of competitiveness over the years since adopting the single currency. With their narrow industrial bases and labour costs relatively high compared with non-EU countries, the periphery has seen its share of world trade falling steadily, in turn increasing its reliance upon financial market inflows.
As the latter have dried up in the last two years, so the underlying weakness of these economies has become increasingly exposed. A key reform for these countries is greater labour market flexibility and changes to restrictive working practices, which would encourage greater industrial diversification.
Reform of public finances is another key area, and one that has long been neglected in some of the peripherals. Elimination of excessive bureaucracy and waste, and changes to retirement ages and pension entitlements, are all areas that will need to be addressed to help bring down fiscal deficits and put public finances on a sustainable long-term footing.
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